Wednesday, October 28, 2009

There have been a few broker notes out suggesting that the GSE preferred stock is going to zero. The preferred stock itself has been dreadful lately – retreating almost to our original purchase price.

I think the broker notes are wrong – but lets do this formally because if you look at the assumptions in my model and the assumptions in the broker notes you can make up your own mind. [I will lay out their assumptions and my assumptions clearly – you decide.]

The first “GSEs are zero” broker note was produced by Keefe Bruyette & Woods (one of the few brokers left covering the stocks). I have reproduced the note here (and claim fair comment use for doing so).

The core assumption is that the GSEs are closed – and that they are put into very rapid run off – and that they do not earn much money during this run off period. Here is the revenue model for Freddie Mac.

(You will need to click all the tables in this note for details.)

There are implicitly a lot of assumptions here.

The first core assumption is that the net interest yield (after hedging costs) on the retained portfolio will be about 1 percent over the long run. I agree. In the bad-old-days Fannie Mae used to report about 120bps, Freddie Mac used to report about 80bps. When they restated their results Fannie restated the results down and Freddie restated them up. The right number was about half way between the Freddie and Fannie numbers – so 100bps is as good an estimate as any.

The second core assumption is that the short run hedged interest margin is also 1%. This is flat wrong. Fannie and Freddie are getting absolutely record interest spreads at the moment – absolutely shooting the lights out. I detailed this here. This model assumes that Freddie has net interest income of $8 billion this year – which is rather difficult because they are currently getting over $4 billion per quarter. The high current net interest margin is a function of three things:

Firstly – and most obviously – the lack of competition in the mortgage market. That is not going away in the short term – and it would be crazy to assume that net interest margins compress to 1 percent rapidly.

Secondly the Fed is being more than generous with the shape of the yield curve. That is going to end – but possibly not that rapidly.

Thirdly – and this is important – there were several charge offs of derivatives which were used to hedge the net interest margin when the businesses went into conservatorship. Those hedges are still there (but they have been written off up front rather than amortised over the life of the product). As a result reported net interest margins will be higher in the short term.

All up I would expect the net interest margin over the first two years to be maybe 12 billion dollars cumulative higher than this model. Indeed as those numbers are currently being reported it is perverse to argue otherwise.

The third core assumption is that the company is put into massive and sudden runoff. This is a political decision that – as far as I can tell – has not been made. You can see this in the numbers because the owned portfolio (and for that matter the guaranteed portfolio) is assumed to drop 20 percent per year from now. This is a far more aggressive assumption than the government is currently indicating for Fannie or Freddie. Indeed last month Freddie’s owned portfolio actually rose a little. Moreover no government official has so far indicated that Fannie or Freddie will have to get out of the guarantee business – and this model assumes that they must leave the guarantee business.

In my long series I made it clear that the value in the preference shares depended critically on the companies being allowed to stay in business – at least for a few years. That is true of the value of almost every bank in America – in that the whole sector is dependent on the pre-tax, pre-provision profits from their current business to cover their credit losses. If it were not for pre-tax, pre-provision profits even big (and sacred) companies like GE would not really be viable.

If we just assume the portfolio remains flat for three years we can add another 10 billion to Freddie’s pre-tax, pre-provision profits.

Now it is possible that the Government might choose to put the GSEs into rapid run-off (and there are Wall Street firms who crave the interest rate hedging business and who would like it) but if the GSEs are put into rapid run off it would have profound (and negative) effects for the price of conventional mortgages and for any housing recovery. I think it is reasonable to assume that they are not insane – so I think three extra years income is a reasonable assumption. However again I am just exposing the assumptions.

The fourth issue is simple double counting.

Freddie in the KBW model is assumed to write no new business. If it writes no new business it can incur no credit losses on that business.

They are going to have credit losses on the old business (but they count them below). Counting additional credit losses is double counting.

It would (of course) be reasonable to assume credit losses would be incurred on new business – but KBW is asserting that there will be no new business.

The extra credit costs in the KBW model add up to another $6 billion over ten years.

I think on reasonable assumptions – including a rapid run off of the book after three years the pre-tax earnings of Freddie are thus 28 billion higher than in the KBW note. Nonetheless I am just reporting the assumptions implicit in the argument that Fannie and Freddie are permanently impaired.

Credit losses in the KBW note

There is no real model of credit losses for the existing book in the KBW note. However they do give a chart with base case, stress case and best case.

Note the cumulative loss in the best case is $33.7 billion at Freddie Mac. My model was a little worse than the best case - $37.6 billion of losses still to incur (so over 40 billion cumulative losses on the book). Since I wrote that, there has been a solid bounce in the demand for houses around the $200-300 thousand dollar mark (that is largely GSE foreclosures) in the key bubble states. This video from Jim the Realtor (who is usually a dour bear) explains just how strongly the San Diego area has bounced.

It is pretty clear from stories like this (and there are many more) that it is much easier to clear inventory. My model assumed that it was going to get much harder and that severity on the book would rise from the current 43 percent to about 50 percent.

Now this bottom-end housing bounce could be “the mother of all head fakes” – but again – like the interest margin – I am only reporting what is happening now. The housing market could take another big swan dive and then my model will be wrong. That is the bet I spelt out in the long series.

Anyway we should look at the current losses – and projected forward losses. The last Freddie Mac quarterly credit supplement gave the credit losses, provisions and reserves by quarter.

In the second quarter the cash losses on the Freddie guaranteed mortgage book were $1.907 billion. Cumulative cash losses have been a bit over 5.8 billion dollars.

My model assumes that the future losses will be roughly 6.4 times losses booked to date. That is my estimate is consistent with the housing market getting dramatically worse. The evidence for that is thin.

Not only is the anecdotal evidence (such as Jim the Realtor) pointing the other way, but foreclosures are up only 5 percent from summer to fall. Housing bears treated that news as evidence of crisis – and I thought it was a remarkably good number. The foreclosure moratoriums have expired and we are not swamped by foreclosures. My estimate that cash losses on the existing book are likely to be about 6.4 times the so-far-recorded losses does not seem low.

That said – the base case in the KBW note have cash losses being 10.1 times already booked losses. That seems unreasonably high with the strong evidence of a turn in the housing market. The stress case (which are the Congressional Budget Office numbers) are for end losses to be 24 times the amount of losses already recorded. If you believe that then depressive illness is probably the best diagnosis. Surely you should not be doing stock analysis – and it puzzles me why the CBO should be putting out such patently ridiculous estimates.

That said – KBW uses their base case in their model (59 billion of cumulative losses) and I use my base case (37 billion). There is a further 22 billion difference between my assumptions and theirs.

I note that they do not justify their 59 billion number – and I went to great lengths to justify mine. However if the housing market takes another massive turn downwards theirs (not mine) will be right. If the housing market continues to bounce (as it has) then we will both be wrong – losses will be lower than either of our estimates.

The non-mention of write-backs on the private label securities

The KBW note does not make any mention of the possibility of write-backs on the private label securities. I went to some lengths to show why – at least in Freddie Mac’s case – those write-backs were likely. I produced an estimate of about $10 billion. These write backs are reflected in part in current market prices for these securities.

This adds another 10 billion difference between my model and the model used by KBW. The total difference is thus $60 billion.

You can do a little bit better than that too – because Freddie will earn some return on the 60 billion it does not lose – but lets ignore that.

KBW’s solvency model

KBW then presents a solvency model for Fannie and Freddie. I reproduce it here:

There are some nuanced differences between my model and their. My model of losses is a model of losses not yet recognised whereas they provide an estimate of end-cumulative losses. That differs by the losses recognised to date ($5.8 billion though KBW state incorrectly that they are 8 billion). These add to the difference between the KBW model and my model.

Also Freddie Mac currently has a 7 billion dollar positive capital position (remember it made a profit last quarter and it had write backs of the private label securities). KBW has ignored that (something I consider another pure date-input error). So you could add another 15 billion benefit to Freddie on my assumptions over KBW.

Add the 60 billion to the net capital position as estimated by KBW (the –39 billion at the bottom of the table) and it is pretty clear that Freddie can repay the shortfall and make the preference shares whole. Add in the remaining 15 billion (being the chargeoffs to date and the current net worth of Freddie after profits last quarter) and it repays easily.

A plan for Obama

Reform of the GSEs is quite tricky at the moment. The jury is still out on their end losses. Moreover the ether is full of self-interested lobbyists who want to take the good bit of their business (mostly interest rate risk management) and leave the bad bit (credit risk management) with the government.

Winding down the GSEs right now runs the risk of killing the nascent recovery in the housing market.

The sensible course of action is to just wait. This is policy that can be delayed without any real additional risk to the government. (The government is already on the hook for the losses.)

If my math is right – and I think it is – then the GSEs will appear solvent in time for the 2012 election. The government can demand (and receive) almost 100 billion in capital to be repaid from them (which will make the budget look good and undermine the only viable Republican argument that the Democrats are irresponsible). It will make the government look like good conservators of key institutions. It will make Obama look like safe hands for running America.

The anti-GSE lobby knows this is a possibility and they are determined to capture as much GSE business as possible right now – so they are vociferous in their claims. Sensible people should ignore them.

24 comments:

Maria
said...

I think this KBW note was a hatchet job. Moreover, the sell off was not selling done by people following the analyst, but rather the note was the explanation for selling.

It took me untold amount of time to bid for those securities. I'm still up ~3X at these levels (for how long?). The liquidity was atrocious, and the only way to pick up any shares was to sit on bids to see someone trading around you. I think I did a good job, and they were out of favor at the time I was buying. I bought in 2 volleys. One in December 08 and one in March 09. I got enough for me, but for a hedge fund, I can see a serious limitation on liquidity.

If I wanted to get them in massive quantity, I would try to tag the arbs with the common to force losses and liquidations on divergence, followed by an all out attack. However, the volume sold is still tiny. What was accomplished, though -- fear was put in owning the securities. 10K market order can move almost any series a $1 either way.

I appreciate your posts regarding GSE pfds. I also think you almost should not be an American to see the trade.

I also doubt on the final result being $0 comp on pfds, because FRE subs were redeemed @~110. That's interesting given the current state of FRE. It may have been a screw up on the part of FHFA to allow FRE to redeem subs, and I suspect it was a nod to the treasury 10% pfds divvy. However, that redemption puts the conservator of an entity in an interesting position had FHFA chose to wipe out FRE pfds. An asset one tier above was redeemed @~110, yet pfds are @ $0 without BK court approval? Isn't BK court designed for exactly those situations?

Bronte Capital should be a consultant for the US gov on these two companies. It seem this firm sees clearly the value of these two firms and shows the international markets do as well.

I note owning both Freddie and Fannie stock I am very excited about the numbers this REAL investment firm is posting and should be noted by all as more valid that KBW.

John, many many investors have read your study and most likely are holding due to it. i for one are in a holding pattern collected 10"s or thousands of shares with the view that nothing is going to change now and that an exit plan must be easier to leave the giants alone-let them heal and payback the tax payor.

Only wallstreet wants to dismantel FRE/FNM.

I hope this quarters numbrs are good for both and we see a change in view as well the GOV just to say we stand by the conservitorship.

Good luck on your investment!

A proud American not proud of bullcrap American investment houses fake and fraudulant numbers.

Great job on this analysis. I wrote my own rebuttal to the KBW piece. It is here:

http://blog.gatorcapital.com/126/rebuttal-to-gse-worthless-analysis/

It will be interesting to see Freddie's earnings report. I agree the write-up of the non-agency positions will be a nice positive. The headwinds will be lower interest rates during the quarter and the pressure on the loan loss provision from continued rise in past due loans.

i've been reading you regularly in the last few months. I've also made some money going long on BTA and short on SWHC and i'm greatfull for this. I hope i can contribute with some contrarian ideas in the near future... i'm trying to work in that.

I've been trying to identify what are the GSE preferred shares you're talking about, but so far with no success. All the preferred stocks of Freddie Mac i've been analyzing are over 1.4 usd, not anywhere near the 2 to 4 cents you were talking about.

Can you give us the symbol? If you prefer not to do it, no problem, i'll keep reading your blog anyway :)

Well Put Maria. With regard to your last question, re: BK court, there was a Wash-Post article on some Dem legislation:http://www.washingtonpost.com/wp-dyn/content/article/2009/10/26/AR2009102603260.html

What upsets me is this line "The intent of the new authority would be to give a government agency the power to take over a failing firm and dissolve it outside of the bankruptcy process"

If passed, it seems the us-gov would have no threat from a BK judge if they were to shut the gse's down. I don't like the sound of it.

Alessandro: it's cents on the dollar, not just cents. For example, the FRE.pr.z preferred is at about $1.05 today, but has a face value of $25, so it's trading for about 4 cents on the dollar.

JH: Sorry I don't comment more, but I am out here reading along! As long as Alessandro is mentioning BTA, it makes me real sorry I didn't spend more time trying to figure out how to buy an Australian security from here in Canada!

the outcome may or may not be favorable but the process is wrong :). i'll let you know why next week when i arrive in town if you tell me if st. vincent is the best hosp in town? need a cardio checkup pronto.andy

We accumulated various series of Fannie and Freddie preferreds amounting to about $20,000,000 in liquidation preference earlier this year. We still hold the position and are prepared to accumulate more if the KBW silly season continues.

What struck us, as another poster pointed out, was the remarkable lack of liquidity in these preferreds in light of the huge number of shares outstanding in the larger series (for example FNM/PS - 280 million shares; FRE/PZ - 240 million shares).

These series were impossible to buy in any size except on Mondays or Tuesdays when the FDIC was dumping failed bank inventory.

This causes me to believe that most of the Fannie and Freddie preferred shares remain in the hands of the smaller banks that bought them before the Paulson rape.

I am led to two conclusions from the above: 1) Since small bankers are a canny lot, they do not continue to hold securities they have written down unless they have some reason to believe they will have value again within a reasonable period; and 2) the Obama administration, also a canny lot, must realize that merely a partial resumption of preferred dividends by the GSEs would pump more capital into the smaller bank balance sheets than the TARP funds recently allocated for that purpose.

"The sensible course of action is to just wait. This is policy that can be delayed without any real additional risk to the government. (The government is already on the hook for the losses.)"

John--What makes you think that? I would think the sensible course given the current path and political climate would be a good bank/bad bank-type solution. I.e., seize on the current insolvency to definitively zero out the common and preferred, and spin out the losses and re-capitalize a "Good" FnF as a viable going concern.

Put another way, what's the downside of Geitner/Summers pursing the current path to it's logical conclusion? Wiping out shareholders (and the residual value of the Pfds on bank balance sheets)strikes me as politically more viable than sustaining the capital structure of zombie GSEs so that hedge funds can reap a windfall from the gov't safety net.

Love your blog and look forward to the promised post on your withdrawal from the pain meds.

John, was this piece put out before the U.S. housing numbers release this morning? How do you reconcile your positive view of housing with these numbers and the numbers for delinquencies comming out of MTG recently. Thanks for any response.

Flaneur,Isn't the downside that many regional banks may hold these securities? This a guess, not someting I have verified. But by wiping them out the government would be hurting those banks, while if their value returns near par, it is a hidden stimulus to those banks.

"Isn't the downside that many regional banks may hold these securities? This a guess, not someting I have verified"

Me neither, Jim. But lets assume that banks still hold 50% of the preferreds. Say $6B, which I assume has already been marked to market/written down. John's thesis is that in 5+ years time, the prfds CAN potentially be made whole.

No argument about the precarious state of the regional banks, but I doubt that a potential recovery of $6B for bankers and hedge funds in 5-7 years is the foremost consideration of the politicians and regulators. Rather, my guess is that a)maintaining liquidity in the mortgage market; b) repayment of the gov't prfds; and c)some sort of meaningful reform of the GSEs trump the desire to see recovery of the prfds.

1) Given the redemption of the sub debt at a premium, doesn't that create a problem for wiping out the preferreds?

2) Have you heard anything regarding the financial reform currently being discussed extending to FRE and FNM?

3) If they wipe out the preferred doesn't it hamper their ability to recapitalize in the future? I sure would be less trusting.

4) I have noticed that most people seem to lump all the equity together and I think that is a mistake because in the case of FRE and FNM the preferred was qualified for bank investment because of the implicit guarantee. While I don't think there is value in the common, I think there is value in the preferred, for the reasons mentioned above.

I am concerned about the current legislation that could give authority to wipe out the preferred without consideration to what transpired with the sub debt being taken out at a premium to par. Anyone with legal background please feel free to reply also.

Lastly, I am perplexed as to why the government has been so SLOW to reduce the rate on the senior preferred (current 10%). Surely there has to be an underlying reason. I mean, they do it for the banks but why not FnF? Any thoughts? It seems the government is trying to create insolvancy.

this analysis -- actually mostly a reiteration of your previous analysis -- still leaves a few questions.

first, what were the changes at FRE/FNM after conservatorship? were they pushed into making/insuring bad quality loans or was that the job of the FHA?

second, it looks like the 2008 vintage is shaping up pretty poorly if you look at FRE's cumulative loss rates. clearly the recession is part of the problem here. any thoughts?

third -- and this is where i've been banging my head against the wall -- it looks like the govt is kind of in a trap with respect to resolving their status.

you could be right that the government is likely to let them earn their way out of the hole they are in, but there are other possibilities such as in-place recapitalization (the treasury could convert some of their sr prefs into common stock aka citigroup) or a good bank / bad bank split. both of these options could be positive for the preferred shares but neither would get them near par.

neither you nor anyone else i've read has gamed out these possibilities publicly and i would be interested in hearing what you have to say.

The fact that the government is even contemplating the sale of tax credits is a sign that they believe the credits are worthless if held by Fannie (which needs taxable income to benefit from the credits). Goldmans would pay at most 25-50% of the intrinsic value of the credits so this would be a very bad deal for the shareholders if the company ultimately returns to profits.

I've followed your reports on the GSE's with great interest (very thorough job with this).

Today, Sec. Geithner, answering a question posed after a lecture he delivered, reportedly said that on April 15 and in testimony he will give before Congress tomorrow (March 23), Pres. Obama would release questions to guide the debate over the future of housing finance. He added that the administration recognized two bedrock principles, that families need access to mortgages even in bad economic times and that the GSEs will not continue in their current form of shareholder-owned businesses with implicit guarantees. He also stated that risk-taking, capital adequacy, and solid underwriting are required in the mortgage market, and that Treasury and HUD will put out requests for comments on an overhaul of the housing finance system by April 15.

Here are a couple of the juicier quotes:

“It should be clear that the government is committed to ensuring that the GSEs have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any of their debt obligations.... The administration will take care not to pursue policies or reforms in a way that would threaten to disrupt the function or liquidity of these securities or the ability of the GSEs to honor their obligations.”

“Private gains can no longer be supported by the umbrella of public protection, capital standards must be higher and excessive risk-taking must be appropriately restrained.”

It sounds like the administration wants to keep the GSEs in business, though this is all vague enough and early enough that it's hard to know whether they'd want to throw them into receivership first, how they plan to recapitalize the GSEs, and whether the GSEs have a sustainable business model without an implicit or explicit government guarantee.

I wonder whether you have any thoughts on the implications of these remarks for the Freddie and Fannie preferreds.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.